Analysis Big Mac Index

5/21/2018 Analysis Big Mac Index

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OBJECTIVE

OBJECTIVE 1: To calculate the Big Mac Index of 5 countries.

Price of Big Mac in local currency for the 5 countries was obtained.

Using the exchange rates, the prices of Big Mac in various countries was converted to

US$ price.

Implied PPP (also the Big Mac index) was calculated using the Big Mac price in local

currency and the Big Mac price in US.

The currency of a particular country is checked with respect to the actual exchange rate

and seen if it is overvalued or undervalued which tells us about the strength of a

particular currency.

OBJECTIVE 2: The analysis of the PPP exchange rate to be done for a basket of goods is

what we are trying to accomplish in this end term project.

In this project we have taken a basket of goods consisting of 15 goods ranging from all the

possible areas that is staples to entertainment.

Our basket of goods consists of the following enlisted items:

a. I phone

b.

I pod


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INTRODUCTION

Purchasing power parity (PPP) is a theory that the exchange rate between two currencies is in

equilibrium when the purchasing power of currency is the same in each country. If a basket of

goods costs 100 in the United Kingdom and $150 for an equivalent in the United States, forequilibrium to exist, the exchange rate would be expected to be 1 = $1.50. If this were not the

case, arbitrage would be expected to take place until equilibrium was restored.

It is an economic technique used when attempting to determine the relative values of two

currencies. It is useful because often the amount of goods a currency can purchase within two

nations varies drastically, based on availability of goods, demand for the goods, and a number of

other, difficult to determine factors.

Purchasing power parity solves this problem by taking some international measure and determining

the cost for that measure in each of the two currencies, then comparing that amount.

The basis for PPP is the "law of one price".In the absence of transportation and other transaction

costs, competitive markets will equalize the price of an identical good in two countries when the

prices are expressed in the same currency.

There are three caveats with this law of one price:

(1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can

be significant.

(2) There must be competitive markets for the goods and services in both countries.

(3) The law of one price only applies to tradable goods; immobile goods such as houses, andmany services that are local, are of course not traded between countries.

The PPP being an important index of measurement of a countrys currency being undervalued or

overvalued, many goods have been used time and again by researchers to develop indexes based on


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PPP. The currencies listed belo

local currency is overvalued by t

expected to depreciate against th

the local currency; the currency i

One of the primary uses of purchasi

national currency. This is particular

example, if the riel falls in value to

will also drop to 80%. This does nouse of GDP), however, because the

that will not yet have had any effect

however, we are not misled by the t

still costs 9,000 riel in Cambodia an

same.

are compared to the US Dollar. A green bar in

he percentage figure shown on the axis; the cur

e US Dollar in the long run. A red bar indicates

s thus expected to appreciate against the US Do

ng power parity is in lessening the misleading effec

ly an issue when calculating a nation's Gross Domes

80% of its value on the dollar, the GDP as expresse

accurately reflect the standard of living in that coudevaluation of the riel is most likely due to internati

on the average Cambodian. By using purchasing p

emporary devaluation of the riel in relation to the d

d $3 in the US, and so our Big Mac index exchange

icated that the

ency is thus

undervaluation of

llar in the long run.

s of shifts in a

tic Product. For

in US dollars

try (a commononal trade issues

wer parity,

llar a Big Mac

rate remains the


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METHODOLOGY

Collected raw data of basket of goods for various countries for the year 2007.

With the available data, the basket of goods price in US$ with respect to the local

currency is calculated using the formula:

Basket of goods price in US$ = Basket of goods price in local currency * Indirect

Exchange Rate.

The PPP Exchange Rate is calculated as :

Basket of goods price in local currency / Basket of goods price in US

Then to check if the currency is undervalued or overvalued, the following formula is

applied:

100 * (PPP derived Exchange Rate Direct Exchange Rate) / Direct Exchange Rate.

The difference and trends of the PPP derived Exchange Rate and the Direct Exchange

Rate for every country is plotted on the basis of which the analysis is made.

Also the trend in the valuation of the currency as obtained from the PPP is plotted.


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1. Big Mac Index

The Big Mac Indexis an informal way of measuring the purchasing power parity (PPP) between

two currencies and provides a test of the extent to which market exchange rates result in goods

costing the same in different countries. As stated in The Economist, it "seeks to make exchange-

rate theory a bit more digestible".

One suggested method of predicting exchange rate movements is that the rate between two

currencies should naturally adjust so that a sample basket of goods and services should cost the

same in both currencies (PPP). In the Big Mac Index, the "basket" in question is considered to be

a single Big Mac burger as sold by the McDonald's fast food restaurant chain. The Big Mac waschosen because it is available to a common specification in many countries around the world,

with local McDonald's franchisees having significant responsibility for negotiating input prices.

For these reasons, the index enables a comparison between many countries' currencies.

The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big

Mac in one country (in its currency) by the price of a Big Mac in another country (in its

currency). This value is then compared with the actual exchange rate; if it is lower, then the first

currency is under-valued (according to PPP theory) compared with the second, and conversely, ifit is higher, then the first currency is over-valued.

The Big Mac Index computed for the year 2007 is given as follows :


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ANALYSIS

The table above shows the prices of the Big Mac burgers in different countries, after

converting to US Dollars. The cheapest burger in this list is in China, where it costs an

equivalent of $1.45, compared with an average American price of $3.41. This implies that the

yuan is 58% undervalued. Further, On the basis of this index, we can see that neither the euro

nor the pound is undervalued - though the Japanese yen, South African rand, Singapore and

Australian dollars certainly are.

Chinas Yuan was the most undervalued currency, with Hong Kong coming a close second .

A currency which is quoted or traded below what is perceived as its true market value, given its

country's balance of payments position, economy, interest rates and so on. An undervalued

currency will be in demand as traders and speculators believe it will rise and therefore will buy

it to make a profit.

The Swiss Franc, at 53%, was the most overvalued currency.A currency whose quoted or

traded rate is above what the market believes to be its correct level, given its country's balance

of payments position and other relevant factors. Traders and speculators would be reluctant to

buy a currency they believed to be overvalued as that suggests it should fall.

The Economist does not include the Indian Rupee in the Index. This is because the Big Macburger that is used for comparison, is not sold in India(as it contains beef).


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The iPhoneis an internet-conne

Inc. with a flush multi-touch scr

which is affected by local labour

same and the iPhone is a tradeab

2. Iphone

ted multimedia smartphone designed and mark

en and a minimal hardware interface. Unlike th

and transport costs, the iPhone manufacturing

e commodity.

eted by Apple

e Big Mac,

osts are the


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Countries

Price in

Local

Currency

Convert

Price in

UK 99 196.

Canada 223 192

Australia 59 41.9

Japan 23000 205.

France 99 22.2

India

(2008) 31000 698.

Graph-1: Comparison of the

Graph-2: Comparison of the

.

.

.

.

.

Year 2007

ed

S$

Price

in US

PPP derived

Exchange

Rate

Actual

Exchange

Rate

(Indirect)

Actual

Exchan

Rate

(direct

764 199 0.497487437 1.9836 0.5041

.258 199 1.120603015 0.862143 1.15

915 199 0.296482412 0.710833 1.40

617 199 115.5778894 0.008951 111.72

1375 199 0.497487437 0.224381 4.45

703 199 155.7788945 0.022538 44.

PP Exchange Rate and the Actual Exchange Rate f

UK, Canada, Australia, France

PP Exchange Rate and the Actual Exchange Rate f

Japan and India

eOver

Valued/Under

Valued

4 -1.31839

9 -3.38796

8 -78.925

5 3.448084

7 -88.8373

7 251.0906

r Iphone for

r Iphone for


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Graph-3: Showing if the c

rrency of the particular country is overvalued or un

dervalued


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ANALYSIS:

1. Looking at the prices of Iphone across the countries we see that it is most expensive in

India and almost priced 250% more than its price in USA.

2.

However, the price in Australia and France is way much less.

3.

From the comparison of the currency valuation we see that there is not much variation in

the actual and PPP determined exchange rate of the Iphone between the countries, though

it is very high for India whose currency seems to be highly undervalued with respect to

the pricing of Iphone.


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The Ipod index is a comparison

world. The Apple Ipod has beenused to form the basis of a purch

real value of international curren

that it is better because iPods are

Ipods do not vary across differe

3.Ipod Index

f prices for the popular iPod nano music player

judged to be so universal in its appeal, that its pasing power parity index (with a basket of one)

cies. Its originator, the Australian Commonwea

traded internationally. Further, the input prices

t countries.

across the

rice is beingto measure the

th Bank, claims

of producing


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Countries

Price in

Local

Currency

Conve

Pric

US

Australia 242 1Austria 271 1

Belgium 5830 2

Brazil 583 3

Canada 167

China 1392 1

India 9862 2

Japan 16494 1

Mexico 1670 1

Singapore 230 1

Sweden 1376 2

Switzerland 199 1

Taiwan 5348 1

UK 98 1

Graph-4: Comparison of t

Graph-5: Comparison of t

Year 2007

rted

in

$

Price

in US

PPP derived

Exchange

Rate

Actual

Exchang

e Rate

(Indirect)

Actu

Excha

Rat

(dire

2.36 149 1.624161074 0.710833 1.2.86 149 1.818791946 0.710833 1.

5.81 149 39.12751678 0.0353 28.3

7.71 149 3.912751678 0.5618 1.77

44.2 149 1.120805369 0.862143 1.1

9.84 149 9.342281879 0.129184 7.74

2.27 149 66.18791946 0.022538 4

7.63 149 110.6979866 0.008951 111.

4.46 149 11.20805369 0.09249 10.81

1.25 149 1.543624161 0.69879 1.431

3.03 149 9.234899329 0.1548 6.45

5.59 149 1.33557047 0.88 1.13

4.88 149 35.89261745 0.03083 32.4

5.04 149 0.657718121 1.9836 0.50

e PPP Exchange Rate and the Actual Exchange Rat

e PPP Exchange Rate and the Actual Exchange Rat

al

nge

e

t)

Over

Valued/Und

er Valued

068 15.45074068 29.28573

861 38.12013

993 119.8184

599 -3.37052

897 20.68733

.37 49.17268

255 -0.91968

198 3.663289

045 7.866913

948 42.95624

364 17.5302

594 10.65694

134 30.46497

e for Ipod

e for Ipod

()


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Graph-6: Showing if the c

rrency of the particular country is overvalued or un

()

dervalued


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ANALYSIS:

1. The Ipod, one of the most common goods in todays time is priced only at $149 in the

US, however it is priced maximum in Brazil at $327.

2. The Ipod is cheaper than the US price only in Japan and Canada.

3. When comparing the PPP derived exchange rate and Actual exchange rate based on Ipod

prices we see that there is not much variation between the two for Japan, Canada,

Taiwan, Mexico and Australia.

4.

There is a great degree of difference in the currency valuation of Brazil and its currency

is undervalued to the extent of almost 120%.

5. For all the other countries however we see that the valuation is to the maximum of +/-

50%.


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CONCLUSION

Looking closely at the PPP argument, it states that the currencies purchasing power should not

change when comparing the same basket goods across countries, and these goods should all be

tradable. Hence, if PPP is valid at all, it should be captured by the relative price indices that bestfits these two features. Estimation of purchasing power parity is complicated by the fact that

countries do not simply differ in a uniform price level; rather, the difference in food prices may

be greater than the difference in housing prices, while also less than the difference in

entertainment prices. People in different countries typically consume different baskets of goods.

It is necessary to compare the cost of baskets of goods and services using a price index. This is a

difficult task because purchasing patterns and even the goods available to purchase differ across

countries.

The Big Mac Index and the Ipod Index are two of the common price indices used today.

Economists widely cite these two indices as a real world measurement of purchasing power

parity.

One way that iPod is a better measure than Big Mac, according to CommSec, is that the latter is

made in host countries while the iPod is predominantly made in China. But the iPod still does not

meet all the PPP criteria. Freight costs vary and some countries get volume discounts. The

centrally manufactured iPod will not incorporate changes in domestic costs. But the iPod is

tradeable across borders and it is the same across the globe. So it may provide a purer assessment

of currencies than the Big Mac.

However, the Big Mac Index has been pretty accurate so far and the Ipod Index is only in its

early stages. It remains to be seen which amongst the two would find greater acceptance in the

days to come. The PPP exchange-rate calculation is controversial because of the difficulties of

finding comparable baskets of goods to compare purchasing power across countries.

Analysis Big Mac Index

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